In Defense of ARMs They're Neither 'Evil' Nor 'Toxic'

As the mortgage and housing crisis wends its way toward an inevitable solution, we've been told all too often that Adjustable Rate Mortgages (ARMs) are either the cause of -- or at the heart of -- the market's failings, putting borrowers and lenders alike out on the street.

These claims have rattled their way across the political landscape, as well, with the Consumer Finance Protection Agency for a time even considering banning all but "plain vanilla" mortgage products. As they of course present different risks than do fixed-rate mortgages -- it's a safe bet that at least certain ARMs -- vilified as they have become -- wouldn't be included in any list of approved "vanilla" products.

However, arguments that ARMs are "evil" or "toxic" simply aren't supported by the facts. While it's true that most subprime products were ARMs and have a spectacular record of failure, and that even some 'prime' ARMs have failed as well, it's also true that many ARMs haven't failed, and may have even provided tremendous value to their holders. Of course, it always helps to fully understand one's mortgage.

It's also a fact that ARMs, in varying forms, have been a part of the residential mortgage marketplace for more than a quarter century. A product with a 25-year history can't be all bad, or it would have disappeared from the market. Some 'flavors' of ARMs today are, in fact, fading from view as consumers have moved away from them -- even old standbys like the traditional one-year ARM. Like every financial instrument, they're not meant for everyone, nor are they always useful.

It's important to note that ARMs were born of a need brought on by high interest rates. They were based on the premise that borrower and lender alike should share the risks in an ever-changing marketplace. In exchange for accepting such risks, the borrower benefits from a somewhat lower starting rate plus a chance at a lower interest rate in the future -- perhaps even declines which might persist for years. This is an important qualifier that you'll want to remember for later in this discussion.

The Product, or the Borrower?

While the forensics into the failure of certain ARMs will go on for years, it's worth noting that there is a distinction which needs to be made between the product itself and how it is utilized.

Suppose one needs to buy a vehicle. There are lots of choices, and all will get you from point A to point B. What type should one get? A buyer must decide what kind of vehicle best suits his or her needs, whether it is a sports car or a dump truck. It goes without saying that the two are meant for different purposes and aren't interchangeable, and a buyer selecting the wrong one will find an ill fit for their needs. This is also the case with financial products, including mortgages, which were developed to address certain time frames, needs and goals.

The oversimplified point is that some, if not many, of the problems with ARMs were not caused by the product, but by how it was applied relative to the user's needs or wants.

It's also worth saying that the sellers (salespeople) at that car lot are interested in selling you something and will try to present you with as many choices as they can in order to make the sale. They can't make a living if they don't make sales, and for the most part, their role isn't to help you decide what kind of vehicle is right for you. This may change in the future.

That said, we agree that, if an ARM borrower failed due to circumstances beyond his control -- malfeasance, steering, predatory lending practices, and such -- then let's expose and, if warranted, prosecute those bad mortgage actors to the fullest extent of the law. But to overly restrict or even ban access to a product which has proven to be helpful and useful to many hundreds of thousands - perhaps millions - of borrowers is just plain nuts. Why penalize all borrowers, now and forever, for the failings of some of yesterday's? It just doesn't make sense.

Value, and Opportunity

A product which offers a lower-than-market rate for a period of time offers both the promise of savings and an opportunity for homeownership which otherwise wouldn't have existed. Even if 50% of all subprime ARMs failed (and some studies put it near those levels), that still leaves a 50% success rate -- and lot of people owning homes who might not have become homeowners otherwise. Fixed-rate subprime loans were rare and expensive all throughout the housing boom, with rates in the high-single- and low-double-digit range. For borrowers, a high interest rate restricts the size of the loan one can qualify for; for lenders, a high interest rate means a increased likelihood of the borrower refinancing at some point, so few lenders were interested in making them available.

This being the case, it's also necessary to segregate certain audiences.

Prime borrowers can choose to select an ARM if it fits their needs, while borrowers with weak credit histories have had little choice but to accept them if they wanted credit. This is a crucial distinction as well, since a sizable chunk of the jumbo mortgage market -- loans made to the most well-off Americans -- were ARMs, and by the choice of the borrower.

Payments, and Risks

It's also worth evaluating the various payment structures overlaid onto ARMs. Some methodologies can compound the risk of ARMs... but these are payment choices, notmortgage products. A product which allows a borrower the chance to increase his or her loan balance, for example, a kind of increasing leverage over time, can have significant repercussions regardless of whether the product has a fixed interest rate or not. As well, even PayOption ARMs allowed the choice of a fully-amortizing payment.

Payments which require only interest for some period of time also have well-understood implications when they change to include the payment of principal (that is, they become fully amortizing). For the most part, these are are knowable outcomes; deferring payment necessary to amortize the debt -- let alone not even paying all the interest which is due -- can cause borrowers trouble when increases in the required payment occur, whether the underlying mortgage product is fixed or adjustable.

Whether anybody took the time to discuss these considerations and outcomes with borrowers when the product was being originated is a discussion for another day; both lenders and borrowers have responsibility in this regard. However, we need to keep in mind that available choices of payment methods aren't themselves mortgage products -- they're an option that can be added to any loan, just as power windows can be added to any vehicle. It's to those options, then, that the regulatory and legislative focus should turn. Any "consumer protection" discussion should center on whether the public would benefit from a regulation that residential first mortgage loans must not allow for negative amortization -- or, perhaps, that the borrower must be qualified on the required fully-amortizing payment for the remaining term. To these could even be added other kinds of qualifiers, all to help ensure that the borrower can afford the loan under any realistic scenario.

It's our opinion that homes and mortgages should never be sold solely on the basis of monthly payment alone. Of course, for a time, that's just what happened. Promising a starry-eyed prospective homebuyer the chance to own a $400,000 five-bedroom colonial in the tony part of town for only a few hundred bucks per month is irresponsible, especially if that low, low payment lasted for just perhaps six months before the payments would increase.

In this way, borrowers who were allowed, prompted, or wanted to stretch their incomes to the limit just to qualify for the initial payment (or who were allowed to leverage their incomes into extra-large mortgages) were among those who shouldn't have got an ARM -- or, perhaps, any mortgage -- as they were probably teetering on the edge of fiscal solvency to begin with.

There's also something to be said about the frequency of interest rate changes. Even some venerable products are fading from the market as consumer interests have moved elsewhere. Short-term ARMs -- those with up to a one-year interest rate change frequency -- have, at times, caused borrowers trouble in times of quickly rising interest rates, since they can produce ever-higher monthly payments in rapid succession. There are good reasons why borrowers have gravitated to hybrid ARMs with longer delays before the initial adjustment occurs, chief among them the stability of the monthly payment for at least a reasonable time horizon (or for a desired time period).

ARMs when rates are high

As noted earlier, ARMs were developed in a time when fixed-rate mortgages (FRMs) were prohibitively expensive. Rates were well into the double digits in the early 1980s, and few borrowers were interested in locking in those high rates for a full 30 years, even if they could qualify for them. The earliest ARMs didn't offer any discount on the initial rate -- no 'teasers' here -- but instead the opportunity that your mortgage rate and monthly payment would decrease as market interest rates returned more toward normal levels.

Because of this, ARMs can be a very good, valuable choice when interest rates are high, because there is an opportunity for the borrower to benefit, perhaps significantly, when interest rates decline from their peaks.

ARMs when rates are low

Of course the reverse is also true. When interest rates are low -- at or close to historical lows as they were earlier this decade -- the only way they can actually move is upward. And so we wonder how many homebuyers asked their lender: "With interest rates at rock-bottom levels, why should I get a mortgage whose interest rate is far more likely to rise than fall?" And how many lenders pointed this out to their borrowers? Was there no realization -- on either side -- that interest rates couldn't get much lower, and that higher monthly payments were all but a certainty?

We wonder about the mania so evident in the recent housing boom, which fostered a "buy a house at any cost" kind of mentality. There's much, much more to homeownership beyond "Can I afford today's monthly payment?" Since owning a home is generally a longer-term prospect than, say, a car lease, the proper question to ask is "Will I be able to afford tomorrow's obligations?" At the very least, this is a concept which used to keep prospective homebuyers awake at night. Over the past few years? Not so much.

Who else might benefit?

As noted above, so there's at least one audience for whom ARMs are a valuable component. Are there others? Certainly.

Buying a small apartment but planning on a growing family within a handful of years? Why pay the cost for a fixed rate for a full 30 years when you plan on moving up within a few years? Various fixed-rate periods available on ARMs means you can get all the fixed rate (and level payments) you might ever want or need without the expense of buying a full 30 years' worth of fixed payments.

Closing in on retirement age, and thinking of shedding the McMansion, while wondering how you'll generate cash to more fully fund your retirement accounts? Let's say that you have a five-year window until retirement is likely to occur. Recasting your remaining loan into an ARM -- even a "risky" interest-only payment model -- can maximize your cash flow and serve to secure your retirement to a greater degree.

Before you laugh, consider this: A $200,000 6.5% loan taken 10 years ago by a 52-year-old would carry a monthly payment of $1,264 -- and that payment will remain constant until the home is slated to be sold (five years in the future).

A refinance to a 5/1 interest-only ARM at 5% would see that payment, for the next five years, (until the borrower is 67 years old and ready to sell/retire) drop to just $706 per month, adding more than $550 per month to cash flow. True, the borrower wouldn't be building any more equity (excepting any home-price appreciation) but the cash-flow improvements are impressive and potentially valuable.

Even if the payment is a fully-amortizing one ($910 per month), this still produces better than a $350 per month improvement in cash flow, while paying off some $14,000 of the outstanding balance over the next five-year period, to boot.

We could probably come up with a few more audiences who need of could utilize various ARMs to good effect... but you should have the idea by now.

What to do if inflation spikes?

As we mentioned, the push for "plain vanilla" product by any new agency would likely come at the expense of offering ARMs. Some of the "consumer protection" concepts under discussion will require a lender to retain up to a 5% interest in the product (a substantial capital requirement), impose new disclosure and education requirements, and even possibly ascribe certain liability to the lender for any borrower failure.

This, coupled with other factors which will probably lead many lenders to abandon ARMs. (This trend was already evident, to a smaller extent, in 2008). A large number of lenders -- perhaps most -- will simply say "We don't offer those products anymore." Smaller lenders, in particular, expressed concerns that such restrictions will rob them of their ability to meet their customers' needs. Although some might approve of the disappearance of ARMs, we should again point out that ARMs present their greatest value when interest rates are relatively high -- a threshold as low as perhaps 8%, give or take.

The coming need for ARMs

For the moment, interest rates are low. We can assure you with 100% certainty that this will not be the case forever. While no one knows how high interest rates may go during an economic cycle, there are growing concerns that the "pull-out-all-the-stops" methods employed to cushion the economic downturn may turn into a nasty spike in inflation.

An inflation spike will push up interest rates, particularly long-term interest rates -- like those found on, say, 30-year FRMs. With the housing market expected to be in a fragile state for some time, and with low interest rates a key component of recovery for housing, what would happen to the housing market if interest rates visit 7% or 8% -- or even approach 9%, as they did in the beginning of this decade?

Absent ARMs, how severe might the collapse in home sales be?

As "affordability" is the intersection of a home's price and financing costs, how much might demand for housing and home prices be crushed (again) with fixed-rate mortgages at 8% and no lower-cost options available? The difference in the amount of mortgage you can borrow at 6% versus 8% is substantial, and the home sale market can only function if borrowers can afford to buy. Without ARMs, there will be no lower-cost options available, and the market would probably come to a complete halt until either incomes rose or prices fell... more likely, a combination of both.

It's also worth noting that ARMs can be a useful tool for spurring the housing market. New home sales have been weak for several years, and builders are holding a fair bit of hard-to-move existing inventory. A major national builder recently began offering a 7/1 ARM with an interest rate of 3.875% -- more than a percentage point and a half below even conforming 30-year FRMs -- to buyers of its houses.

Over a period of seven risk-free years, a borrower who took that 7/1 over a comparable 5.5% 30-year FRM with a $250,000 loan amount would save some $244 per month -- about $28,000 in total interest costs over 84 months -- while also retiring some $7,500 more of the loan's principal balance over that time compared with the 30-year FRM.

ARM critics will note that "anything can happen after that!", and to a degree, that's true. However, nothing prevents the borrower from refinancing out of that ARM without penalty at any time... and it's also quite possible that the borrower will have closed out the loan by moving, too. "Anything can happen!" is true, but we'd also like to see even a grudging acknowledgment that there may be positive, risk-free outcomes, too. As the risks are knowable, they might even be ameliorated to a great degree with a little bit of disciplined planning on the borrower's part.

How many ARMs succeeded over the years?

While critics are quick to point out how many ARMs have failed in this "perfect storm" of liberal lending policies at a time of rock-bottom interest rates, the fact is that many ARMs did not. There probably have been many millions of success stories over the 25-year history of the product, and many homebuyers and refinancers have enjoyed opportunities for homeownership and saving money that ARMs have provided.

Still think they're "toxic"?

A wide range of available choices in mortgage financing benefits everybody. It serves to help promote housing demand, which keeps home values firmer than they would otherwise be. At their core, ARMs remain valuable to specific audiences who can and have used them to great effect over the years. In this way, they are a 'niche', product, no different than any other 'niche' product. It is only when the those outside the 'niche' either stumble or are crammed into it does it create a problem, for lender and borrower alike. It is a fact that certain mortgage choices are intended to fit certain applications, and regardless of the product, issues will arise when an improper choice is made.

While we don't think ARMs are toxic or evil, we would agree that there needs to be a better, clearer and simpler way of disclosing how a given product will work -- in best-, typical- and worst-case scenarios. We think loan documents need to be much more explicit in how a borrower might be harmed, particularly if an ARM is coupled with any form of non- or partially-amortizing payment method. We think that no mortgage should be sold solely on the basis of initial monthly payment, let alone see borrowers qualified at artificially-low interest rates.

However, we do believe in choice, albeit informed choice, and we do believe that innovation and evolution of mortgage products matters. Just as certain products in the mortgage markets have come and gone -- due to consumer and lender choice (two-step balloons, anyone?) -- we think which products survive and which do not should come as part of that natural process of the marketplace weeding the 'good' from the 'bad'. We would hate to see innovation or consumer choice quashed by regulators over-reaching in the name of "consumer protection".